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The Complete Guide to Investing in Commercial Property

23 March 2017

Not only does commercial investing involve acquiring warehouses in business districts, but it can also mean snapping up retail space, childcare facilities, restaurants, hotels, car parks, medical centres and even digital billboards.

While many are sceptical of investing in commercial real estate due to the perceived higher risk (compared to investing in residential property), commercial property can provide significant cash flow benefits, greater rental certainty due to longer rental periods, and fewer ongoing expenses.

If you do your research, practise due diligence and understand the risks involved, commercial real estate could be a valuable addition to your property portfolio – an option that you may not have previously had on your radar.

Why invest in commercial property?

Con Tastzidis, managing director of CST properties and business real estate specialist, says that investors can reap several benefits from investing in commercial real estate, such as the flexibility of use, potential redevelopment opportunities, longer lease periods.

“It’s easy to manage, as you have less emotional tenants. You’ve also got the lease contract, which sets out exactly what the requirements are, and with non-payers it states basically how you can get rid of them”, he says.

“There’s flexibility to adapt, as you can change a run-down motel, depending on the zoning, to a retail residential development, or it could be re-developed or rebranded. In a Sydney beachside location, we purchased a motel and changed it into a backpacker hostel which was more profitable. Other options which may be possible (subject to council approval) include strata, motels or hotels. I’ve worked with developers that have owned hotels and decided to strata the rooms. They were then sold off individually with guaranteed returns to cater to a small investor", he says.

Some additional advantages of investing in commercial real estate are outlined below.

Pros of commercial property investment

Higher return: Commercial property generally provides a higher return on investment (ROI) compared to residential properties. According to CoreLogic (2015), the average rental yield for commercial properties, such as a warehouse, is between 8-10%, whereas the rental return for residential properties is 3.6% on average.

Longer lease period: The average lease for a commercial property is between 3-10 years, whereas the lease for a residential tenant may be just 6-12 months with no guarantee of renewal. Commercial tenants tend to stay in the premises for longer, particularly if they’ve invested some capital in acquiring the property from the outset. For example, if the tenant decides to upgrade the fit-out of the space by investing $50,000 into the project, this will provide you with some certainty and security of rental income which can facilitate your cash flow planning.

Fewer ongoing expenses: For commercial properties, the tenants typically cover rates such as council, water, insurance or body corporate fees, so there are fewer ongoing costs compared to managing a residential property.

Value-adding activities: For well-chosen commercial properties, tenants are likely to make improvements to the structure and layout of the space, which can increase the property’s value. As rent is reviewed annually, this means you can charge a higher rental amount to better reflect the upgraded premises following an improvement.

Price stability: The value of commercial real estate is set by expert property valuers. Commercial property prices have historically shown lower levels of fluctuation compared to other investment types.

Price appreciation: Lease agreements often contain a term for rent increases in accordance with inflation. Because valuations are determined by the level of rent paid, commercial property prices tend to rise over time.

Cons of investing in commercial property

In terms of the risks of investing in commercial property, Tastzidis suggests that some of the greatest drawbacks can be a lack of property knowledge and research, letting to the wrong tenant and not inspecting the property adequately.

Lack of research. Tastzidis says that investors need to pay attention to market forces when researching: “Landlords can be strong minded and they’ve got a certain price in their mind which they won't deviate from. They then ask for higher rent, which is very hard to achieve in the current market conditions, and consequently they have the place vacant for 6-12 months, and they lose much of their revenue. However, if they reduced their rent by 10% over the whole year, they would have had 90% of their income if they reduced the price by 10% and decided to be flexible.” In addition, not inspecting the property properly and not having the full knowledge of potential changes to fire or council regulations could cost “hundreds of thousands of dollars, if not millions,” he says.

Untenanted periods: Commercial properties run the risk of being untenanted for extended periods of time, such as months or even years, which means you may have to cover expenses during the interim until you can find another tenant.

Vulnerable to economic factors: An economic downturn, rising interest rates, high unemployment or poor business confidence may mean that there is less demand for commercial property, which could mean that it’s difficult to find quality tenants.

Costly upgrades: Although the cost of upgrades will depend on the type of property, renovating a commercial property, such as a retail or office situation, may be relatively expensive compared to renovating a home. This is because upgrades for a commercial property may require a greater scope of work for a larger area and include major tasks such as the removal of asbestos, fire and safety issues, changing the fit-out or restructuring the space to meet the tenant's business needs, whereas upgrades to a home may include inexpensive tasks such as painting or installing new appliances.

Camilla

Camilla has been tossing up between purchasing a one-bedroom apartment in Woollahra or a small childcare centre in Turramurra, NSW.

After speaking with a property investing specialist and projecting her estimated cash flow, Camila decides to invest in the private childcare centre as it was only marginally more expensive compared to the apartment, and she believed it could potentially provide greater return as she wouldn’t have to worry about covering maintenance or council expenses. What’s more, Camilla conducted some research and discovered that infrastructure projects, transport links and services surrounding the childcare centre were likely to increase the accessibility of the area and potentially boost up property prices.

After consulting a lending specialist, Camilla soon attracted a corporate tenant who signed a five-year lease and spent $40,000 on a new fit-out. Camilla reviewed the annual statements of the company and conducted a cost-benefit and risk analysis to discover that the company had sufficient financial resources to meet the rental payments.

Camilla was satisfied with the quality of her tenant because she believed that the tenant’s initial investment would add significant value to the property, and it would also ensure that the tenant remains in the property for at least the five-year lease period.

How does commercial property investing differ from residential property investing?

It’s important that you understand that investing in commercial real estate differs significantly from investing in residential property. While you still rent out the property and receive rental income from the tenant as you would with residential investing, there are some core differences.

Tastzidis says that commercial properties generally have longer lease periods and less restrictions. They can be a less emotional purchase, they often feature set pre-determined rent increases, and they can be more flexible if investors practise due diligence.

With regard to changes in property value, Tastzidis says that commercial property prices can have a dramatic impact on returns: “Commercial property prices generally don't increase that much, but price movements can affect rental returns in certain areas. On the other hand, I've seen some spectacular price increases over the years mainly due to zoning changes. I did hear of one property that was originally purchased for $200,000 and then sold for $4 million around a year later", he says.

The core differences between commercial and residential property investing include:

Vacancies between different tenants tend to be longer for commercial property.

Unlike residential property investing, the Goods and Services Tax (GST) applies to the purchase, income and expenses associated with commercial property. This means you should allow for an additional 10% on top of the property purchase price if the property is vacant. However, the good news is that you can claim this back under an ‘input tax credit’.

Maintenance expenses are typically covered by the lessee of a commercial property, which means that rental income is generally higher than the return generated from residential property.

Commercial investment objectives

Before investing in commercial real estate, you need to think about what you’re trying to achieve from the investment. For instance, you may want to think about the purpose of your investment, such as one of the following:

Diversify your portfolio. Are you investing in commercial property to diversify your portfolio and minimise your investment risk by purchasing a different property type in a different area?

Income. Are you trying to maximise your return? If so, what’s your expected rental return? Have you looked at average rental yields for similar properties in the area?

Capital growth. Is achieving capital growth your main objective? If so, how much do you hope to gain and by when?

Tax benefits. Are you investing in non-residential property to reap the tax benefits such as claiming back GST?

Degree of risk. You’ll need to determine the amount of risk you’re comfortable with pursuing for this investment. Will you take steps to reduce your investment risk such as sourcing a ‘blue chip’ client or ensuring that you have a sufficient buffer of funds to cope with potential unvacated periods?

What to consider when buying commercial property

When investing in commercial real estate, Tastzidis says that investors should be aware of local prices and market conditions, council restrictions and zoning regulations, and the condition of the property including any safety hazards.

Reviewing a potential tenant is one of the greatest considerations for your investment, and Con Tastzidis says that it’s important to check their references and previous business experience: “Look at the references, past history and business experience, but it’s also important to go on your gut feeling, as most of the time I can tell by just talking to them", he says.

Tastzidis maintains that the ability to manufacture favourable terms and finance conditions is another important consideration: “You can manufacture contractual conditions to suit both parties, taking into account available finance, cash flow, period required to obtain approvals, period required to obtain or complete visibility studies and/or approvals from council”, he says.

Location

When selecting the location of your commercial property, you should consider its accessibility to transport hubs, surrounding business enterprises that could offer support to your tenant’s business, as well as a lack of similar properties in the suburb to ensure that there is not an oversupply of commercial properties.

Infrastructure developments

Review current infrastructure plans that are currently underway, but also consider future infrastructure developments that could put upward pressure on property prices. You can do this by logging onto the local council website or speaking with local real estate agents.

Tenant quality

Find a strong corporate or ‘blue chip’ tenant that has financial resources to meet the rental payments and is unlikely to default on the rent. You should also review its business model, brand assets, annual statements, resources and even industry trends to determine whether or not this is a suitable tenant.

Building structure

Consider the structure or ‘bones’ of the property and whether the layout can be easily changed to attract different types of tenants. A multi-purpose space can also help you attract a wider pool of potential tenants.

What factors influence demand for commercial real estate?

A major factor in commercial property growth is demand, which is largely driven by economic indicators such as population growth.

Interest rates

The current low interest rate environment will support demand for both property and borrowing. However, rising interest rates could potentially dampen demand for commercial real estate, as the cost of finance and rent becomes more expensive.

Infrastructure projects

Large infrastructure projects can boost demand for commercial property. For instance, the development on the M7 in Sydney generated demand for warehouse properties in the surrounding precincts of the M7.

Population demographics

Australia’s ageing wave of baby boomers has greatly increased demand for health care services such as aged care facilities and medical centres. For example, federal government expenditure on health care services and facilities is expected to increase from 15% of total Commonwealth expenditure to 25% by 2050.

Population growth

Suburbs with strong population growth undergoing gentrification may require new services such as shopping centres, financial service companies and restaurants.

What are the risks of investing in commercial property?

Vulnerable to economic shocks

During an economic downturn, demand for commercial property generally falls due to sluggish economic growth and poor business confidence. Tastzidis says it’s important to consider whether or not the investment may be susceptible to major economic downturns: “I noticed a pub once which opened for six months near a mine and then closed down another six months later. The pub went from thriving to nothing almost overnight,” he says.

Lease terms

While long lease terms can be advantageous in providing rental certainty, they can also present a risk in the sense that it may take longer for you to find a tenant once the premises are vacated. If your property is vacated for an extended period of time, you’ll need to ensure that you’re well equipped to cover the carrying costs until you can find a new tenant.

Property size

Keep in mind that larger commercial properties may be more difficult to lease than smaller properties and will typically be more expensive to hold.

Changes in supply

It’s a good idea to keep tabs on the supply indicators of the area. For instance, an increase in property within the area may create a threat since existing tenants may look to upgrade or expand.

Who can purchase investment property?

Individuals, trusts and companies can purchase investment properties. For individuals, an ideal structure to use is a self-managed super fund (SMSF), which can also provide investors with tax benefits.

How can I finance a commercial investment property purchase?

Most commercial property loans work in a similar fashion to residential home loans. You can choose from variable, fixed or a split rate, as well as making principal and interest or interest-only repayments.

Generally, banks will lend up to 60-70% of the property value, but this loan-to-value ratio (LVR) is also based on the potential rent or yield that can be generated from the property. You generally need to complete a deposit of at least 30% of the property price to gain approval for a commercial mortgage, but this will depend on the lender’s individual terms. If you’re an existing homeowner, you can typically borrow against the equity in your home.

Tastzidis points out that interest rates may be higher than those for residential home loans, but he says your ability to access finance may depend on how the lender classifies the loan type: “Banks tend to put a generalisation on the type of property. For example, for boarding houses, some banks classify them as commercial, but I've had cases where a bank has classified it as residential which means it's valued much higher and it's easier to get approval. That's why it's good to shop around with the banks."

You may want to consider a line of credit commercial home loan that provides you with funding up to a set limit so you only pay interest on the funds drawn down.

What should be included in the lease?

You should carefully consider the following when reviewing the terms of the lease:

Term: Leases are generally 3, 5 or 10 years, and they often include an option for renewal.

Fees: Determine whether or not the tenant will cover expenses such as utilities and insurance body corporate fees. This is normally the case, but you will need to ensure that this is clearly stated in the lease.

Upgrades: Identify whether or not the tenant will be able to make physical alterations to the property. Generally, the tenant can make changes as long as they ensure that the property is handed over in its original condition when the lease expires.

Council approval: Ensure that you check with the local council authority to see if the tenancy requires approval, such as medical centres. Leases over a certain value may need to be registered with the relevant state authority, such as the Department of Lands in NSW.

Advice for investing in commercial real estate

Tastzidis emphasises the importance of knowing the market price, doing your homework, making sure you’re using an experienced agent and trusting your gut feeling to some extent.

When determining the cap price, it’s important for you to consider the calibre of the client: “I’ve seen properties lease for well below the market rentals. Again, there are generalisations in the commercial property industry. For example, in retail situations you may have cap rates between 6-7% but if you have a blue-chip tenant such as a major food chain, such as KFC, or a major department store, the percentage could be as low as 3-5% return on long leases".

“Check with councils and see if there are any developments around the place, such as a service station opening down the road or rezoning. In country areas, consider new roads like new highways that bypass through a town, closure industries, vulnerability to climatic conditions and, on the positive side, new developments or infrastructure.

Finally, he points out that no commercial property is 100% passive, and it’s important that you have a clear understanding of the purpose of buying the investment. “Are you prepared to find its highest and best use and put in the work to maximise its value and investment return? Don't forget that one day the property will be sold. Unforeseeable personal and business problems occur. Good planning before and after the purchase would significantly enhance the chances of a good investment return and a handsome Capital gain on the future sale. As they say in any business situation ‘failure to plan is planning to fail’,” he says.

Other ways to protect yourself and maximise the benefit of your investment include:

Buffer of funds

Due to the risk of having long periods of a vacated property, ensure you have a cash buffer to cover running expenses, such as council rates, body corporate fees and insurance.

Capital gain

When you invest in commercial property, it’s likely that you will make more from capital gains than from rental income, so ensure that you carefully assess tenant quality. Increased income from tenants and a better quality of tenant is what will attract buyers in the future, which will generate higher capital gain in the long term.

Minimise investment risk

Ensure that your tenants are being managed appropriately and consider taking out a fixed interest loan to manage your cash flow. Lessen the risk of major maintenance expenses by ensuring that the property is adequately inspected prior to your purchase to ensure that there are no major structural issues with the property.

Market research

Make sure you inspect the property yourself prior to purchase, check out similar properties in the area and undertake market research to find out about average rental yields and property prices in the area.

What are some myths about commercial property investing?

According to Tastzidis, one common misconception about commercial property investing is that it’s more difficult to manage than residential and riskier than residential property. However, if you practise the right due diligence, commercial property can be a relatively low-risk investment.

Another major misconception is the belief that capital gain is limited with commercial real estate: “Generally, it's as good as residential but there are spectacular gains sometimes,” Tastzidis says. “Another misconception is that it's too difficult and you have to have a lot of money to get involved.”

Tastzidis says that another common myth about commercial property investing is that it is highly risky for properties outside capital cities, but he says that this is not always the case: “Capital gains growth can be achieved in regional areas that have consistent population increases, a proactive council, good transport, reliance on more than one industry and stability of major industry in the town or area”, he says.

A summary of major misconceptions about commercial real estate are:

You need a higher capital outlay: While many believe that commercial properties require a larger initial outlay of cash, this is not the case. There may be some commercial properties that go well into the millions, such as high-rise buildings or large warehouses, but you can also buy well-located offices for between $300,000 and $550,000, which is a similar price tag to a small apartment. However, unlike an apartment that may provide you with 3-4% yield, the office could generate 7-8% rental yield.

Commercial tenants are difficult to manage: Although this will vary depending on the quality and type of tenant, commercial tenants are not always difficult. As they are running a business from the property, it’s in their best interests to ensure that maintenance and upgrades are conducted when required.

It’s more expensive to manage commercial real estate: Management fees for commercial properties are actually lower on average compared to those of residential properties. For commercial real estate, you’re looking at paying 3-5% in management fees compared to around 7% for residential properties. You can also avoid paying capital gains tax (CGT) when you sell commercial properties.

Are there any particular industries that are on the rise?

When we posed the question to Tastzidis, he said that it largely depends on the type of investor, their experience and how much risk they are prepared to endure.

“Retail investments are generally the more conservative investment because tenants usually have to outlay a lot of money to set up, so they are reluctant to walk away”, he says.

“Childcare, motels, hotels and medical centres can give great returns, but you must have the right operator. Cafes and restaurants can be good, but care must be taken to ensure that the operator has the ability to achieve food sales to pay rent. Serviced apartments have been popular, with some showing good returns, but they have been marred by bad developments and high management costs eating into revenue.

“There are many good country regions that offer good opportunities, for example a lot of people don't realise that Newcastle is around twice the population size of Darwin. Look for areas of new infrastructure, new industry or new residential developments.

“All you need to do is go on the ABS site, Google or the Department of Planning. Look at growth industries, such as healthcare, childcare and low-cost accommodation. Again, look at current and planned infrastructure, it's not rocket science."

The rise of car parks

A popular option for investors is to purchase a car park space and rent it out. This is because the availability of car park spaces in new developments in CBD locations is limited which means there is sufficient demand for car park spaces in central locations. Car parks can be a viable investment because they require a lower outlay and require little maintenance but offer high yields. It is believed that some users are willing to pay $70 a day for a sought-after car space.

What areas in NSW may be good pockets for commercial property investment?

According to Tastzidis new residential developments that support new business and are close to new railway lines and other new infrastructure may represent a viable investment location.

For instance, Tastzidis says that locations such as Eastern Creek and other growth areas such as south-west Sydney including Liverpool and Belmore may be good investment areas due to major developments occurring.

“Eastern Creek is pretty good as it's close to the expressway and close near ports. The government is pumping a lot of money in Parramatta, Liverpool, Penrith so these areas may be good investment locations too. Suburbs near the south railway station in the south-west of NSW could be worth having a look at as they’re rezoning the area out that way through Belmore and Canterbury”, he says.

Frequently asked questions about commercial property investing

Is it safer to invest in residential or commercial property?

The debate about whether it’s better to invest in commercial or residential real estate has divided many. While some argue that residential property is less risky, others argue that commercial property is less risky due to its higher cash flow and capital gains potential.

However, investors need to review their portfolio, finances and their strategy to work out which type of property investing would best suit their individual situation.

What’s a fixed rental uplift?

Some lease agreements will include a clause for a fixed rental uplift, which may be fixed to 3-4% per year by inflation.

How would I go about increasing my rent?

As mentioned above, the lease contract should include a clause about the process for increasing rent, and the amount in which rent can be increased.

According to Tastzidis, for most leases, you can have 3% of the Consumer Price Index (CPI) or $1,000 a year, but retail leases are only one item, so you can have a CPI increase or a fixed return increase every year, but you can’t have both. “For example, in property management 18 years ago, I was doing 10% of CPI or greater per year, and that was when interest rates were 15-20%. In retail leases, or most leases, I’d say 80% are CPI increases per year, 10% are 4% per year, and the other 10% are either CPI plus 1-2% or 5% or greater. This is rare and usually in the big shopping centres,” he says.

How are disputes handled in commercial property investing?

Commercial tenancy agreements are normally dealt with as business contracts where the parties involved are not bound by the tribunal system and disputes are typically handled through the judiciary system.

Does GST apply to the purchase of commercial property?

Yes, GST will apply when you purchase the commercial real estate so ensure that you have an extra 10% on top of the property’s purchase price. However, as an investor, you’re entitled to claim this back as an ‘input tax credit’ for GST charged on your rental income.

Are there any other tax advantages?

Some unlisted commercial property funds distributed ‘tax deferred’ income as part of their distributions. As an investor, you can benefit from deferring the tax payment to when the investment is sold, and the treatment of tax can also result in you paying less tax overall.

I’ve heard that health care property is on the rise. Is this true?

Health care is generally viewed as a ‘defensive’ commercial property option as it is less vulnerable to economic shocks. Health care is generally an attractive option to investors, as the outlook for occupancy and development is strong and demand for healthcare services is expected to rise due to an ageing population. For instance, the percentage of Australians aged over 65 years of age is expected to constitute 20% of the population by 2020.

Who manages commercial property?

You can consult the services of commercial real estate agents, who can pair the property with an ideal tenant and attract business by organising deals, such as rent-free periods.

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